Here is the question of the week:
If everyone else is bullish, should you be bearish?
and a corollary -- How do you know?
Most traders take this as an article of faith. Everyone wants to be a contrarian. We all know that a "crowded trade" can easily go wrong as everyone else tries to get out.
This issue must be important, since it was the headline (Sentiment Concerns) in today's Abnormal Returns, the place where I and many other investment pros start our daily reading about the markets. Tadas always presents alternative viewpoints, but the sentiment question is more difficult than most.
I'll return to the question of interpreting sentiment. But first, a review of last week.
Background on "Weighing the Week Ahead"
There are many good services that do a complete list of every event for the upcoming week, so that is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. Others will disagree. That is what makes a market!
Last Week's Data
Last week's data continued the long term story of a slow but solid improvement and lower risk.
Economic news continues to beat expectations.
- Economic growth is improving. The ECRI weekly leading index is at a 32-week high and the growth index, now in positive territory, is at a 30-week high. The ECRI said several weeks ago ago that a near-term recession was off of the table. Each week we have more evidence that they are correct. It is also quite apparent that those who made dubious interpretations of the ECRI indicator were wrong. I tried to demonstrate their error back when readers could still profit from the knowledge.
- Risk as measured by the St. Louis Fed Stress Index, again moved lower during the week. This measure tracks a lot of market data in the eighteen inputs. It is not a poll, nor opinions, nor a collection of anecdotes. The value moved to .23 from .27 last week and .34 two weeks ago. This has been a very nice decrease.
- Risk as measured by the VIX is also lower. (VIX is one of the elements in the SLFSI as well). Some try to place a contrarian interpretation a low VIX level. In this nice guest column for Barron's, Adam Warner (one of our featured sources) explains why current VIX levels make sense but that wilder days may be coming.
- Bonds signal an improving economy. Prof. Hamilton explains why.
- Holiday sales look good. From Bonddad:
The ICSC reported same store sales for the week ending December 18 increased 4.2% YoY, and increased 1.7% week over week. Likewise, Shoppertrak reported that sales increased 5.5% YoY in the last weekend before Christmas. Most of the retailing reports are indicating that this will end up being a strong holiday shopping season.
- The dog not barking. I am not seeing many earnings pre-announcements. It is something I will be watching closely in January.
It was a light week for data, but there was some discouraging news.
- Initial jobless claims (420K) continued in the recent range which is unacceptable for a recovery. Many pundits incorrectly equate reduced initial claims with job creation. They are wrong in their reasoning, but might be right in the conclusion. We need a combination of fewer layoffs and more hiring. Both should be monitored.
- Existing home sales data were terrible. While I think that building permits are a better leading indicator, those have also been awful. The listed supply of existing homes now represents a 9 1/2 month inventory. Most observers think that the shadow inventory adds more months. Calculated Risk has a full analysis and some nice charts, along with some useful interpretive comments.
- Municipality and state debt constitute another looming crisis according to Meredith Whitney. It may not be news to most of us, since she has been on this theme for several months. Telling the story on 60 Minutes raised public awareness, so that was important for the markets. Bond market veterans strongly disputed Whitney's conclusions about the scope of the problem. One of the best published refutations came from Joe Mysak, who challenges the argument that this problem is fifteen or twenty times worse than any prior incident in history. At least Whitney has a time frame on her doomsday prediction. We can all monitor the pace of defaults. As regular readers know, we like to settle questions with data!
- Monetary growth lags, although you would never know it from the incessant and ill-informed commentary about the Fed printing money. Looking at data is always helpful, as Bonddad shows every week:
M1 was down -0.5% for the week and vs. last month, and +7.5% YoY, meaning "real M1" is up 6.5%. M2 was up +0.2% for the week, up +0.3% vs. last month, and 3.1% YoY, meaning "real M2" is up 2.1%. Real M2 remains stalled without being able to break out of the "red zone" below +2.5% YoY.
The Ugly -- Sentiment?
You’d think that the complete recovery from the worst economic downturn since the Great Depression would be big news. You would be wrong. It hasn’t been widely picked up by the mainstream press.
Mark Hulbert, wondering why no one noticed the market climb to pre-Lehman levels, cites Norman Fosback:
Therein lies a tale, which Fosback finds very significant when assessing the stock market’s potential. The lack of attention to the magnitude of the recovery has been caused, in his opinion, by “the extraordinary pessimism enveloping the consumer investing population, fanned by a fear-mongering financial media.” That skepticism, in turn, has played a big role in holding the stock market back from even bigger gains in recent months.
The Pragmatic Capitalist strikes a similar theme:
While high levels of bullish sentiment among advisors, investors, and money managers usually occur at market tops, market tops do not always occur when sentiment is very bullish. Sometimes people respond to the obvious and correctly align their market posture with the price trend. In situations like this we have to wonder whether or not they are wrong.
Bottom Line: An excess of bullish sentiment is a caution sign and should cause concern because such sentiment peaks are often followed by price corrections, if not bull market tops; however, we do not use sentiment as a timing tool, just a indicator to help paint a picture of the market environment. So far we have no indication from our trend-following models that there are major problems ahead.
Regular readers know that over the years I have placed little emphasis on the various sentiment indicators as trading signals. I have three main reasons for my decision:
- The oft-cited sentiment figures have polling issues. The samples are terrible. More importantly the universe of those polled is even worse. I simply do not believe that a poll of fund managers, individual investors, or newsletter writers tells me much. I am much more interested in the actual flow of funds. Behavior trumps poll responses. And this comes from a guy who actually believes in well-executed survey research. Current surveys assert that the AAII people are wildly bullish. I guess I do not know any members!! Every prospective investor I speak with is scared silly, mostly from reading scare stories.
- The marginal dollar in the market represents big pension funds. (No one seems to grasp this, and my data are still sketchy). There is asset allocation going on. When there are changes in expected earnings, corporate bond rates, or similar variables, the asset allocation changes. It is only marginally related to retail investors and mutual funds, the sources most follow.
- I use real measurable data. The actual research does not support the popular contrarian interpretation of evidence like the AAII sentiment poll. CXO Advisory cites a study showing the following:
In summary, German investor sentiment correctly anticipates equity market moves over the next few months to some degree. U.S. investor sentiment used to to be a contrarian indicator for equity market moves over coming months, but its predictive power has disappeared.
The main conclusion? The "contrarian interpretation" worked many years ago, then faded, and has not worked for about ten years. You really need to read the entire article, which has the typical strong CXO methods and explanation.
To summarize, I do not rely on the sentiment polls for market timing, although the Michigan survey is an important input in my employment model.
A Variant Viewpoint
Here is a completely different viewpoint. This source has rocketed to the top of the popularity ratings, despite a multi-year record of inaccurate market forecasts and excuses. Whenever something good happens, it is attributed to a conspiracy. I mention this only because Zero Hedge has a knack for seeing the negative in any indicator. Most recently, ZH has taken the standard view that if sentiment was bullish, it was time to be bearish. This raises the interesting question: What was the ZH viewpoint when sentiment was negative?
So, again, because we fear the bulls may keep their mouths shut here, if the AAII data last month anticipated a massive surge in stocks based on contrarian expectation, today's data confirms that the market is poised for a plunge. Will it? Of course not, because this BS metric has nothing to do with the psychology of the marginal determinant of actual stock prices - the quote stuffers, the primary dealers, and of course, the Federal Reserve itself, which is controlled by a ruthless sith lord completely impervious to such things as mere human "psychological" weakness.
To be clear, I think he means that the AAII data mean nothing, although the recent ZH posts make it seem like sentiment is the death knell for the market. Perhaps some readers can explain this to me.
To keep this in scale, readers of "A Dash" have the equivalent of inside information! The popularity of the big bearish blogs like Zero Hedge is just awesome. As an investment advisor who can sell any product --- gold, inverse ETFs, structured settlements, and all of the other big commission things -- I have obviously blundered. The far easier path to new clients is to sell fear...
Our Own Forecast
We base our "official" weekly posture on ratings from our TCA-ETF "Felix" model. Felix caught most of the recent rally, moved to neutral (but with several trading positions) and turned positive several weeks ago. The number of sectors in the penalty box, a sign of near-term risk, has moved much lower in recent weeks. We are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:
- 88% of our 56 ETF's have a positive rating, down slightly from 91% last week.
- Only 32% of our 55 sectors are in our "penalty box," down from 39% last week.
- Our universe has a median strength of +28, down from +33 last week.
The overall picture was positive during the week, and we maintened a 100% long posture.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list. You can also write personally to me with questions or comments, and I'll do my best to answer.]
The Week Ahead
There is not much economic data due out next week. I do not expect the various regional surveys to provide market-moving information. The politicians will have a lower profile!! Every blip in the market will be obsessively explained by the non-vacationing financial journalists.
CXO Advisory has a nice article on the year-end calendar effects, mostly showing that we should not expect much.
As I said last week, if there is any year-end volatility it is an opportunity for long-term investors. I am using dips to buy for new accounts. Trading accounts remain fully invested.
I also had some advice for long-term investors, advice which is still in force:
The spike in interest rates is also an opportunity for those trying to build a bond ladder. We need to seize chances when they come. We are finding some much better opportunities for yield-oriented investors.
In summary, this is a time to get some focus. Which concerns are real, and which are illusory? If you have a specific concern, can you measure it? How will you know when that worry has been lessened?
If you cannot answer these questions, you need an approach that is more driven by data.